PARTNERSHIP VERSUS CORPORATE ENTITY

A partnership and a corporation are two different legal forms of business entities. There are several well-known legal distinctions between partnerships and corporations. But as Moonitz and Jordan (1964, 6) note, from a financial accounting perspective, the similarities outweigh the differences. Although the accounting for owners equity differs between partnerships and corporations, the accounting for assets, liabilities, revenues, and expenses are largely the same.1 The characteristic feature of both partnerships and corporations is that two or more persons have a joint undertaking for profit. From this characteristic feature flows the commonality of a business or economic entity, separate and distinct from its owners for financial reporting purposes, notwithstanding differences in legal form as discussed below.

Limited Life

Under the law, corporations have an unlimited life, whereas most partnerships legally cease to exist upon the admission, withdrawal, retirement, or death of a partner. However, many large partnerships continue to operate in economic substance over more than a century notwithstanding changes in partnership composition. Several large international accounting and law firms are good examples of such long-lived partnerships.

Absence of Legal Entity Status

Similarly, the absence of legal entity status of some partnerships in some states to enter into some transactions is of little relevance to financial accounting unless legal form is emphasized over economic substance. As Moonitz and Jordan (1964, 45) observe, a partnership has the characteristics of a separate entity in that it may hold title to property in its own name, may enter into contracts, and in some states may sue or be sued as an entity.

Unlimited Liability

Stockholders are not personally liable for the debts of the corporation, whereas individual partners are personally liable for the debts of a partnership, but this distinction is largely irrelevant for financial accounting purposes. For one thing, many creditors require stockholders to guarantee personally any loans to a corporation, yet the corporation still functions as a separate entity. Furthermore, partners may obtain limited liability by making separate agreements to that effect with each creditor, without altering the separate entity status of the partnership for financial accounting purposes. Finally, the personal liability of partners for partnership debt does not be- come significant until the partnership is insolvent; from the standpoint of a going concern, a partnership is surrounded by a wall separating it from the partners in the same sense that a wall separates the corporation from its stockholders.

Moonitz and Jordan (1964, 7) go on to note that it is the intimate relationship between ownership and management that gives rise to most of the financial accounting differences between partnerships and corporations. However, it is here that we part company with Moonitz and Jordan (1964), for they (and most advanced accounting textbooks) are implicitly comparing a publicly

1 Two well-known exceptions are income taxes and owner salaries. Unlike corporations, partnerships are not subject to income taxes at the entity level in the U.S., hence do not report income tax expense for financial reporting purposes. Corporate income is subject to tax at the corporate entity level and again at the stockholder level when distributed as dividends; partnership income is allocated to and subject to income taxes only at the individual partner level. For financial reporting purposes, partner salaries are treated as a distribution of partnership income, not an expense, whereas salaries of stockholders acting as employees are treated as an expense, not a distribution of corporate income. As a result, partnership income is not reduced by the cost of services rendered by the partner-manager, whereas corporate income is reduced by the cost of services rendered by the stockholder-manager. However, we ignore these exceptions in this case.

owned corporation with a privately owned partnership. Although there is a separation of owner- ship and control of many large publicly owned corporations, there is also a separation of owner- ship and control of many large publicly owned partnerships (as well as many large privately owned professional service firm partnerships). Similarly, although there is an intimate relationship between ownership and control of most privately owned partnerships, there is an intimate rela- tionship between ownership and control of most privately owned corporations.

This case deals with a privately owned partnership and a privately owned corporation. For both, income statements are prepared for the same multiplicity of pur- poses, including the two purposes addressed in this case: (1) to facilitate adherence to legal contracts, including the distribution of income among its owners; and (2) to help the owners and management assess past performance, future prospects, debt paying ability, solvency, etc. The case calls for the student to act as a financial advisor, sort through the issues, and advise the parties.

THE SETTINGAN INCOME DISTRIBUTION DISPUTE

Modern Cardiology Group LLP is a privately owned medical partnership. Simon Nave, MD, and John Sophisticate, MD, the managing partner, have an income-sharing dispute while negotiating the renewal of Dr. Naves initial one-year agreement with the medical partnership. Dr. Nave, a recent board-certified cardiologist, is the newest of five partners in Modern Cardiology. The partners share profits and losses equally. Dr. Sophisticate gives Dr. Nave Exhibit 1, an income statement of Modern Cardiology, which shows that his one-fifth equal share of the

$1,000,000 partnership income is $200,000.

Dr. Nave argues that his $200,000 share of partnership income is inadequate given his four years of college, four years of medical school, five years of cardiology residency, and the fact that he is seeing at least one-fifth of the patients and generating at least one-fifth of the patient revenues. Although he does not question his one-fifth share of the partnerships profit, he questions what appears to him to be an unusually high rent expense -72 percent of total revenues. Dr. Sophisticate counters that the rent reflects current market rentals for comparable equipment and facilities, that Modern Cardiologys profit is only $1,000,000, and that Dr. Nave receives his one-fifth equal share; until he generates substantially more patient revenues and the partnership becomes more profitable, an increase is out of the question.

EXHIBIT 1

Modern Cardiology Group, LLP Income Statement

Patient revenues Office and equipment rent expense	$3,600,000	$5,000,000
Technician, nurses, and staff salaries	300,000
Non-owner administrative salaries and miscellaneous	100,000	4,000,000
Net income (loss)		$1,000,000
Dr. Naives share		$200,000

As it turns out, Dr. Sophisticate and two other senior partners of Modern Cardiology own all the voting stock of Technology Properties, Inc. In turn, Technology Properties owns the building in which Modern Cardiology has its practice office and owns the medical equipment that Modern Cardiology uses to conduct various patient tests; it also owns a medical laboratory that operates in the building with the cardiology patients as the principal customers.

However, Dr. Sophisticate does not wish to consider Technology Properties profits in the negotiations with the cardiology partners. He claims that the building and equipment are assets of a separate business entity that were purchased independently from the cardiology practice and financed by the investment of just the three senior partners, and therefore do not concern the other two cardiology partners. As indicated in Exhibit 2, Technology Properties income statement shows a $4,000,000 net income.

QUESTIONS

a.) What is an accounting entity? Is an accounting entity defined differently for a corporation than for a partnership?

b.) How useful is Modern Cardiologys income statement as presented in Exhibit 1 in re- solving this income-sharing dispute? What are its limitations? Does it conform to U.S. generally accepted accounting principles (GAAP)? Does the FASB Accounting Standards Codification Related-Party Disclosures Topic (FASB 2009) provide any guidance?

c.) What is the appropriate entity for assessing the reasonableness of Modern Cardiologys income distribution and profitability?

d.) What is the appropriate entity for assessing the reasonableness of Technology Properties income distribution and profitability?

e.) What advice would you provide the negotiating parties about considering Technology Properties income statement in their discussions?

f.) What does control mean? Does the FASB Accounting Standards Codification Consolidation Topic (FASB 2009) provide any guidance on commonly controlled entities that might help resolve this income-sharing dispute?

g.) Why might Dr. Sophisticate insist on only considering the income statement of Modern Cardiology?

h.) What advice would you give Dr. Nave prior to renewing the partnership agreement?